The price shock pathogen

Baumol’s Cost Disease shows why the inflationary spiral is hard to reverse.

Inflation was so low, for so long, that the seminal work of two New York economists was left largely untouched for a generation. Yet, the world’s problems move in cycles and, amid a price shock not seen for decades, it is time to remind ourselves of a semi-arcane sickness: the Baumol Effect.

First, a recap. Most economists and business leaders would agree with Forbes that inflation was “Enemy no. 1 for the Federal Reserve” in 2022. The causes are manifold: post-pandemic pent-up demand, supply chain disruptions, and a tight labour market. The exact composition of causes varies by country, but the results on their general price indices are similar. In April 2022, the annualized rate of inflation in the UK was slightly higher than in the US (roughly 9% vs 8%).

The standard treatment for inflation is for central banks, such as the Fed, to raise interest rates, restricting the money supply and – everyone hopes – applying the necessary medicine to counteract the current causes of inflation. The emphasis is on the word current – because all the causes cited above could be considered short-run. One might reasonably hope that none will endure for years, particularly the war in Ukraine.

Yet a recent development prompted me to reconsider a longer-run cause of inflation – and recall my old professor at New York University. That longer-run cause was the Baumol Effect – and its eponymous exponent the late professor William J Baumol. Recently, nurses at two major hospitals in New York City went on strike. They were demanding wage increases, lower patient-to-nurse ratios, and better working hours. In this case, the grievances were settled quickly. The nurses and the two privately-owned nonprofit hospitals found a remedy for the dispute. Yet the strike is a classic symptom of Baumol’s Cost Disease.

In 1967, Baumol and fellow economist William G Bowen wrote The Economics of the Performing Arts. The book explained why – over the long-run – rising prices would be a potential problem regardless of global events.

They noted that rising labour productivity enabled manufacturing businesses to pay higher wages without having to raise the prices of their goods. Yet, conversely, they found such an increase in productivity difficult – if not impossible – in the service sector. To paraphrase Baumol, “would you increase the productivity of a symphony orchestra by having it play Beethoven’s Fifth Symphony faster?”

While those in the service sector expect their compensation to keep up with the manufacturing sector, their employer cannot offset these cost increases with increases in labour productivity. Their only option is to raise the prices of their services accordingly, the professors argued.

This phenomenon became known as Baumol’s Cost Disease, or the Baumol Effect. It is an old illness with a new threat: since the service sector in most western economies has become a larger part of the economy than the manufacturing sector, the disease could become an even bigger factor in inflation. Unfortunately, when the price shock is focused on the service sector, it can take more than tight monetary policy to cure it.

There is some room for optimism. At the time Baumol and Bowen wrote their book, China was not yet the ‘factory of the world’. Nor was India the ‘back office of the world’. The rapid advance of technology enables both the service and manufacturing sectors to increase their productivity. Yet, the consequences of Baumol’s disease remain evident in today’s rising fees for higher education, spiralling healthcare costs and – as the pair predicted – inflated ticket prices for shows on Broadway and London’s
West End.

Nevertheless, central banks will continue to focus on interest rates in the hope short-run factors will foster a long-run contraction in inflation. John Maynard Keynes reminded us that “in the long-run we are all dead”. If Baumol’s Cost Disease becomes endemic, long-run inflation might remain very much alive.

Phil Young is an MBA professor and corporate education consultant and instructor.